Tuesday, December 02, 2008

The dangers of harmony

I'm still convinced that many in the financial community deserve far harsher treatment than they've so far received - if they didn't know what would happen, they should have.

But I've been casting about for some deeper structural reason - what allowed financiers to kid themselves that they were acting reasonably, or at least assure themselves that they had followed official guidelines and were "covered"?

So I looked for something relating to the regulation of fractional reserves, and came across references to the Basel Accords (I and II). These are an attempt to "harmonise" central banking policies in developed nations, and perhaps can serve as an object lesson (especially for EU enthusiasts) about international legislation.

Here is the conclusion of an analysis of the two Accords (highlights mine):

One very important fact to assess is the achievements and limitations of each Basel Accord. The first Basel Accord, Basel I, was a groundbreaking accord in its time, and did much to promote regulatory harmony and the growth of international banking across the borders of the G-10 and the world alike. On the other hand, its limited scope and rather general language gives banks excessive leeway in their interpretation of its rules, and, in the end, allows financial institutions to take improper risks and hold unduly low capital reserves.

Basel II, on the other hand, seeks to extend the breadth and precision of Basel I, bringing in factors such as market and operational risk, market-based discipline and surveillance, and regulatory mandates. On the other hand, in the words of Evan Hawke, the U.S. Comptroller of the Currency under George W. Bush, Basel II is “complex beyond reason” (Jones, 37), extending to nearly four hundred pages without indices, and, in total, encompassing nearly one thousand pages of regulation.

The author's concern is that the rules can permit the risk of assets in emerging markets to be understated, and as it turns out the Trojan horse came in through another gate; but in complexity lies opportunity, and in rule-following lies the illusion that personal responsibility is thereby written off.


Wolfie said...

Getting warmer now...

James Higham said...

The problem was, the new Basel II rules created a situation which:

1. was more risk sensitive;
2. created costs to smaller banks and consequently to small-company growth, where the EU lags other regions, and;
3. raised moral hazard concerns in that risks were partly passed to insurers and banks, unlike insurers have potential last resort support from central banks.

Sackerson said...

Wolfie, if you know the answer, out me out of my misery!

James, I struggle with it but you seem better acquainted - was this sort of thing your line of work?

AntiCitizenOne said...

Hooray you've found the root cause.

Mal-Regulation caused this mess and more regulation of the wrong things won't fix it.

Ryan said...

Central planning of interest rates is the root cause of the problem. The belief that you can stimulate real growth by pulling on the central lever that creates more debt.

Financial markets are like a machine. If you give them bad input they give you bad output. The government gave the financial markets seven years of bad input and look - here comes the bad output.

It is, after all, a deliberate policy of government to reduce interest rates to stimulate growth in debt in the hope of stimulating growth in the economy. It ehn believes that the medicine is working because GDP does indeed grow - but only because there is more debt in the systsem and that must pop up somewhere in the GDP figures.

Clearly you cannot go on like that forever, the debt must be paid back.

You can't blame the banks. They would have gone along happily charging rates of 10% and made good returns without taking on undue risk. But the government forced them into lower rates - causing them to shift greater volume and take on greater risk.

The government is to blame, and its faulty interpretation of Keynsian deficit spending. Not onlyshould we stop the government from behaving this way - we should create a constitution that prevents the government from buying votes using debt. If its good enough for the Swiss, its good enough for us.

Wolfie said...

Sackers, maybe I was a bit too subtle on my blog but I have mentioned that I am one of the primary technical architects behind BASEL II and EPE requirement for my employer. I could write you an essay about its strengths and weaknesses but I would be unable to give a satisfactory response as a comment so I'll give you an unsatisfactory summary.

1) It was too little, too late. Most banks are still implementing phase one.
2) "Basel II is “complex beyond reason”" - Nonsense, the overwhelmed need to be shown the door.
3) Insufficient carrot and almost no stick was applied by the FSA.

I actually had regular conversations with management who asked me to "lower their risk" with fancy mathematics. Do I need to point out the oxymoron?

Too many morons in the kitchen spoiled the broth while managers sought to "nourish diversity" and remove "old school tie" images. The result is credit risk is underfunded and full of ethically suitable incompetents. Note quiet rage...

Sackerson said...

Wolfie, missed your previous reference to Basel, sorry. Do you think Basel I made things better or allowed the potential for worse? Would something else have been simpler, clearer, firmer, more secure?

Ryan, thanks for visiting and commenting. But were banks really FORCED to abandon the path of fiscal virtue, ore merely tempted? Should they not have known the consequences?

Wolfie said...

One was not intended to be the full solution, more a warning shot for banks to start getting their house in order. It takes considerable computing power to perform the calculations required for Basel II, they never could have been implemented by any but the larger banks in 1992. Basel II arrived too late, by 2004 the systematic poison was already in place.

This is however irrelevant.

In most institutions the toxic instruments were held off balance sheet and were never reported to Credit Risk. The culprits were protected by unscrupulous management and ignored by regulators.

Sackerson said...

Thank you very much, Wolfie. Your last sentence confirms my view that we ought to be looking at mass fines and jail sentences.

Anonymous said...

"were banks really FORCED to abandon the path of fiscal virtue,"

Yes, they get forced. It becomes inevitable. If interest rates fall then profitability from making loans also falls. If profit falls share price falls. Remember that no-one really cares about share prices two years from now - because no-one that matters is holding shares for more than 2 days. All the banks need to do is show a reasonable progression towards greater profit over the next year. So for the last seven years the banks have done just that. Turned in good profits. Yes they have done this by expanding the volume of loans and therefore taken on greater risk. But nevertheless it was the right business model for the last seven years. Not only that - its the only sensible business model for banks that are competing against each other in the same market. Which bank wants to stick its neck out with a different low-risk model at the same time justifying it by saying "in ten years time we will be the ones that are laughing"? Do you think they will get rewarded by shareholders? Shareholders won't give a damn about what MIGHT happen in ten years (financial armageddon could have taken 20 years after all). Shareholders will happily take a profit today and sell a share tomorrow if they think the outlook might not be so rosy. For every shareholder left holding the banking baby there were seven more that happily took a handsome dividend during the "boom" years.

The only bank that didn't play this game in the UK was HSBC, because they play in the Far East. They are laughing now, but no doubt they will get burnt in the fall-out as the Far East takes a tumble.

The banks have made up their own mind how to solve this problem. They have stuck two fingers up at the BoE and sre now setting their OWN rates. That is how it should be. Banks should run their own affairs. The purpose of government should be to regulate and set boundaries - not directly interfere with the proper functioning of markets. It is not entirely Labour's fault as successive governments have screwed around with interest rates to buy votes, but Labour have been by far the worst offenders.

Sackerson said...

Hi Anon: vigorously argued, in respect of the banks' duty to their shareholders. But their fiduciary duty to depositors? And their duty of care to borrowers? And their moral-financial duty to the country and the international community, i.e. all users of money?